Gold Juniors' Q2'16 Fundamentals

The junior gold miners and explorers have soared dramatically in an amazing
year, before falling hard this week. This sharp correction is doing its job
in rebalancing bull-market sentiment, crushing greed and leaving traders
wary of this sector. But gold juniors' recently-released second-quarter financial
and operational results prove their fundamentals are strengthening dramatically,
a very bullish omen for stock prices.

The junior gold stocks are rightfully considered the Wild West of the gold
sector. Most of the hundreds and hundreds of these small companies won't
prove successful. They won't be able to secure funding to explore sufficiently,
won't be fortunate enough to find an economic deposit of gold to mine, or
won't be able to make the herculean leap from explorer to miner. The odds
are stacked heavily against the gold juniors.

Nevertheless, the elite small gold explorers and miners able to overcome and
grow their businesses to larger scales will see truly-enormous stock-price
gains. The gold juniors are exceedingly important for the entire gold-mining
industry, since they feed the critical gold-supply pipeline with new deposits
and mines to offset the inexorable industry-wide depletion of current operations.
Success here is radically rewarded.

Many of the world's best junior gold miners and explorers are included in
the GDXJ VanEck Vectors Junior Gold Miners ETF, this sector's leading benchmark.
GDXJ began trading in November 2009, and is the world's second-largest gold-stock
ETF after its big brother GDX which tracks larger gold miners. As of the
middle of this week, GDXJ's net assets ran about half of GDX's. This testifies
to junior golds' popularity.

And it's easy to understand why in 2016. Between gold stocks' fundamentally-absurd 13.5-year
secular lows in mid-January and last week, GDXJ blasted 202.5% higher in
just 7.0 months! While I don't have universal ETF data, I'd be shocked if
any other sizable ETF in all the markets even came remotely close. For comparison,
over essentially that same span GDX "only" soared 151.2%. The juniors' gains
have been epic.

But in the single trading week since GDXJ's dazzling new bull high, this ETF
has plunged 14.6% as of this Wednesday which is the data cutoff for this
essay. Seeing over 1/7th of the value of even these elite juniors included
in GDXJ lopped off in a handful of trading days has really unsettled investors.
But it certainly shouldn't have. Gold stocks are a volatile sector,
where sharp bull-market corrections are common.

This important sentiment-rebalancing phenomenon necessary to ensure healthy
and long-lasting bull markets last happened in May, which wasn't too long
ago. GDXJ dropped 14.6% in a month, which also served to eradicate greed
while breeding serious pessimism. Yet out of those very lows, GDXJ would
surge another 57.2% higher by mid-August. That bucked gold stocks' summer-doldrums downside
risks.

Now normally during major mid-bull corrections, investors assume selloffs driven
purely by sentiment must be fundamentally justified. If the junior
golds are falling, surely it's because their costs are rising and operating
profits are falling. But that's rarely true. Corrections are triggered
when greed grows too excessive. That enthusiasm sucks in all near-term
buyers leaving only sellers, spawning sharp selloffs.

With this newest correction underway, we have the great benefit of the junior
gold miners and explorers just finishing reporting their Q2'16 results. Companies
trading in the US and Canada are required by their securities regulators
to file quarterly reports four times a year. These reports are generally
due 45 calendar days after quarter-ends, meaning mid-August. So the latest
junior-gold fundamentals are just available.

This week I dug through the new second-quarter reports for GDXJ's top 34 component
companies. That arbitrary number happens to fit neatly into the tables below.
While GDXJ held a whopping 47 different stocks as of the middle of this week,
the top 34 account for a commanding 93.1% of its total weighting. They include
many of the best junior gold miners and explorers in the business, a great
cross section.

Each quarter I look at these companies' 10-Qs filed with the SEC, or the equivalents
for Canadian and Australian companies. I feed a bunch of data into a spreadsheet
to help me better understand how the individual companies and junior golds
as a whole are faring. The tables below summarize some of the key data, and
prove that gold juniors' fundamentals are strong and improving rapidly.
This is very bullish.

The initial columns show each top GDXJ component's stock symbol, its exchange
traded on, its current weighting within GDXJ, and its market capitalization.
GDXJ is generally market-capitalization weighted, which is the most logical
way to construct ETFs for any sector. That's followed by trailing-twelve-month
price-to-earnings ratios, which are left blank when companies are still operating
at an accounting loss.

Next comes the junior gold miners' costs, the dominant factor affecting their
profitability. Both the cash costs per ounce and all-in sustaining costs
per ounce are included, along with the full-year-2016 projections for AISC
if provided. Then comes cash on hand at the end of Q2'16, its percentage
of each GDXJ component's market capitalization, and the cash flows generated
from operations in the second quarter.

Finally each company's quarterly gold production is included. Somewhat oddly,
GDXJ's managers have chosen to include plenty of the large
silver miners in their "Junior Gold Miners ETF". With so many gold juniors
to choose from, this dilution of focus seems unnecessary. So for the large
silver miners in GDXJ, I listed their gold-only production whenever
provided. No production means a company is an explorer.

Despite this past week's sharp bull-market correction, the junior gold stocks are
thriving fundamentally. Their costs are stable or improving, while
their operating cash flows are soaring. Investors who loved the junior
golds a couple weeks ago ought to be scrambling to buy aggressively now
that their stocks are considerably cheaper. Their rapidly-improving fundamentals
reveal nothing at all to be concerned about.

GDXJ's component list remains very similar to that seen 3 months ago when
I was analyzing this ETF's top components' Q1'16
results. Most of the same companies are still included, although their
relative rankings have naturally shifted with their market capitalizations.
The elite juniors enjoying the biggest market-cap increases, and hence stock-price
gains, have seen the largest weighting increases in GDXJ.

This sector's trailing-twelve-month price-to-earnings ratios are terrible,
making junior golds look wildly overvalued from a classic valuation
perspective. Most of these companies have lost money during the past year
in accounting terms, and thus have no P/Es. And most of the junior golds
that have managed to earn profits have very-high P/E ratios. This apparently-dismal
earnings situation is scaring investors away.

The reason these trailing-twelve-month P/Es look so ugly is the gold-mining
industry was forced to make big non-cash writedowns late last year.
Gold sinking to dismal 6.1-year secular lows impaired the value of gold deposits
and mines. Accounting rules then forced company managers to assume gold's
deep lows would persist indefinitely. So Q4'15 in particular saw massive
writedowns of gold-mining assets.

Even though these are essentially an accounting fiction, non-cash expenses
flushing once-capitalized historic costs out of balance sheets and through
income statements, they affect GAAP profits. So until last year's big writedowns
slide out of the latest four quarters' results, P/E ratios will look ridiculous.
The strong operating profitability of gold miners won't become apparent until
Q4'16's results, collapsing P/E ratios.

If you want more depth on the accounting issues skewing gold stocks' P/E ratios
to scary extremes, last week in my Q2'16
analysis of the larger gold miners of GDX I discussed it deeper. Today's
P/E ratios simply don't reflect the radical fundamental improvements in gold
miners' operations as 2016 marches on. They will eventually, but for now
investors have to look deeper to understand how gold miners are faring.

That starts with the junior golds' cash costs per ounce. With the magnitude
of this GDXJ selloff over the past week, you'd think low-$1300s gold is a
major threat to the juniors. Nothing could be farther from the truth! Cash
costs are the acid test of gold miners' viability, what it actually costs
to wrest each ounce of gold from the bowels of the earth. Gold miners face
no existential peril as long as gold prices exceed cash costs.

Cash costs include all direct production costs, mine-level administration,
smelting, refining, transport, regulatory, royalty, and tax expenses. In
Q2'16, the top junior gold miners included in GDXJ averaged cash costs of
just $636 per ounce. That is actually 2.8% lower than Q1'16's $654,
showing that the gold juniors are still improving the efficiency of their
mining operations despite this year's higher gold prices.

But cash costs are misleading, as they don't include the full costs necessary
to maintain an ongoing gold-mining operation. As gold deposits inexorably
deplete, new ones must be found and developed to replenish current production
levels. So in June 2013, the World Gold Council introduced a far-superior
gold-mining cost measure called all-in sustaining costs. This is rightfully
usurping cash costs' long reign.

AISC include all direct cash costs, corporate-level administration to oversee
gold mines, exploration for new gold to mine, mine-development and construction
expenses, remediation, and mine reclamation following economic depletion.
They are what it really costs per ounce to keep a gold-mining business humming
along at current output levels indefinitely. And the gold juniors' AISC remain
outstanding!

In Q2'16, these elite GDXJ components reported gold all-in sustaining costs
averaging a level of $887. That's a slight 0.7% improvement from Q1'16's
$893. Again the junior gold miners are wringing out new operational efficiencies
even while higher gold prices are removing the pressure to do so. Even more
impressively, GDXJ components' average AISC are identical to GDX
components' average of $886 in Q2'16!

The large gold miners enjoy considerable economies of scale compared to the
juniors. Companies that manage multiple mines save on relative administration
and procurement expenses compared to smaller ones operating single or fewer
mines. So it's pretty darned impressive that the junior golds reported the
same all-in-sustaining-cost structure in Q2'16 as the majors! That's an incredible
show of fundamental strength.

The junior golds' AISC compared to average prevailing gold levels reveal their
true operating profitability that is masked by their writedown-distorted
trailing-twelve-month P/E ratios. Back in Q1'16 as gold was emerging from
last year's brutal rate-hike-fear-driven secular
lows, this metal averaged $1185. At the gold juniors' Q1'16 average AISC
of $893, those gold levels yielded operating profits of $292 per ounce.

Now that's not bad at all considering investors were wrongly convinced the
junior golds were doomed back in mid-January. During Q2'16 the average gold
price climbed 6.3% to $1259. Thus at their latest industry-wide AISC read
of $887 per ounce in that same quarter, operating profits blasted 27.5% higher
quarter-on-quarter to $372 per ounce! 28% profits growth on a 6% gold rally
is certainly very impressive.

This great profits leverage to gold inherent in the junior gold miners
is the dominant reason why they're so attractive to smart investors. Profits
ultimately drive stock prices, and gold-mining profits rocket higher on relatively-modest
gold-price increases. With gold itself in a major
new bull market, the massive surge in gold-mining profits that's going
to generate will be breathtaking. We're already seeing that continue in Q3'16.

So far this quarter, gold has averaged $1341 which is another 6.5% gain sequentially.
Meanwhile the elite GDXJ gold miners projected full-year-2016 all-in sustaining
costs averaging $883 per ounce. That is also incidentally better than the
major miners of GDX which are forecasting $888. That means GDXJ's junior
miners are likely earning $458 per ounce in operating profits so far
in Q3'16, another 23.1% QoQ jump!

At best year-to-date, GDXJ soared 169.1% higher by mid-August. These epic
gains were a combination of a mean reversion higher out of fantastically-bearish
sentiment, and greatly-improving fundamentals. Back in that dark
trough quarter of Q4'15, GDXJ's junior gold miners were earning $293
per ounce with AISC of $812 and gold averaging $1105. In just two quarters,
these operating margins surged 27.3% higher!

And that's just the beginning. Gold mines enjoy such great profits leverage
to gold because mine costs are largely fixed during each mine's planning
stages. That's when mining engineers decide which ore bodies to extract,
how to dig them, and how to process that ore to recover the gold. These costs
simply don't change much regardless of what gold's price does. So higher
gold translates into far-higher profits.

The best proxy of actual profitability of current operations comes from the
cash flows generated by these very operations. In Q2'16, these elite juniors
of GDXJ earned collective operating cash flows of $949m. That was a staggering 51.1%
higher quarter-on-quarter compared to Q1'16's $628m! That trounces the
32.3% improvement over that same span seen by GDX's major gold miners. The
juniors are killing it.

That hard data alone, operating cash flows rocketing 50%+ higher in a single
quarter, provides all the fundamental justification junior golds
need for their far-higher stock prices. And that's only going to keep
improving. Gold itself continues to mean revert out of extremely-oversold
levels from late last year. As recently as 2012 before the Fed's
gross market distortions, gold averaged a normal $1669 per ounce.

While gold will head a lot higher in this young new bull as today's lofty
stock markets artificially goosed to near-bubble
valuations by central banks inevitably roll over into major new bears,
consider that very-conservative 2012 example. A $1669 gold price is only another
third higher than Q2'16's average level. Yet at current all-in sustaining
costs it would catapult gold-mining profitability 110% higher to $782 per
ounce!

With Q2'16's massive leap in operating cash flows, the cash hoards of these
elite GDXJ gold juniors should have exploded proportionally. Yet they didn't,
only climbing 4.1% QoQ to $4571m. The reason is very bullish. The cash-flow
statements from these gold juniors showed many are spending big on
mine expansions or new-mine builds. These will eventually boost their production
and thus future profitability.

One example is Pretium Resources, the largest explorer included in GDXJ under
its symbol PVG. This company is constructing an amazing new gold mine in
northern British Columbia. This $697m project is fully-funded, set to go
live less than a year from now. Pretium's cash balance fell 22% from $367m
at the end of Q1'16 to $287m at the end of Q2'16 because it invested $155m
in its new mine build in H1'16!

Pretium certainly isn't the only elite junior gold miner or explorer making
big investments in growing their future production. It's really exciting
to see the junior-gold industry hit the ground running following that existential
scare late last year and early this year. Investors would be richly rewarded
if the elite junior golds merely reaped gold's coming bull-market gains at
current production levels. Higher ones amplify gains.

I've been studying and trading gold stocks for over two decades now, and each
quarter I wade through their operating results. And the transformation this
left-for-dead sector underwent operationally in Q2'16 simply due to higher
prevailing gold prices was amazing. If a mere 6%ish gold rally can so greatly
boost the junior golds' operating profits and cash flows, imagine what the
rest of this young new gold bull will do.

So if you liked the junior golds a couple weeks ago when they were still climbing,
you should love them today at correction discounts. The best times
to add new positions within ongoing bull markets are after significant selloffs,
not near preceding highs when excitement abounds. Investors looking to ride
the epic coming profits growth in the junior golds can certainly take a stake
in GDXJ, their benchmark ETF.

But GDXJ has serious issues that will retard its ultimate gains. In addition
to its heavy silver focus due to the high weightings of major silver miners
in this "Junior Gold Miners ETF", it is way over-diversified. Too
many holdings dilute the massive gains coming from the best individual gold
juniors commanding superior fundamentals. So why not jettison the deadweight
within GDXJ and just own the best of its stocks?

At Zeal we've spent literally tens of thousands of hours researching
individual gold stocks and markets, so we can better decide what to trade
and when. This has resulted in 838 stock trades recommended in real-time
for our newsletter subscribers since 2001. Their average annualized realized
gains including all losers are running way up at +20.2%! And that's excluding
the big unrealized gains on our books today.

They're as high as 350% this week, with many doubles and triples this year
alone, even after this past week's sharp correction. We've also got a major
new gold-stock and silver-stock deployment underway to ride the coming upleg.
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The bottom line is the gold juniors just reported an amazing Q2'16. The modestly-higher
average gold prices fueled huge gains in cash-flow generation and operating
profitability. Many junior gold miners are plowing these soaring surpluses
into expanding their existing operations, ultimately leading to even higher
production and greater future profitability. The junior golds' fundamentals
are dramatically improving.

Unfortunately most investors aren't yet aware of this hyper-bullish transformation
underway. This year's massive surge in operating profitability is being masked
by writedown-distorted P/E ratios. And this past week's sharp gold-stock
correction has ramped up fear again scaring investors away. For those smart
enough to overcome herd sentiment and study the junior golds' fundamentals,
their stocks are really on sale.

If you have questions I would be more than happy to address
them through my private consulting business. Please visit www.zealllc.com/financial.htm for
more information.

Thoughts, comments, flames, letter-bombs? Fire away at zelotes@zealllc.com.
Due to my staggering and perpetually increasing e-mail load, I regret that
I am not able to respond to comments personally. I WILL read all messages though,
and really appreciate your feedback!

Mr. Hamilton, a private investor and contrarian analyst,
publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis
of markets, geopolitics, economics, finance, and investing delivered from an
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